Monday, August 18, 2014

Kinder Morgan Limited Partners Could Face Steep Tax Bills

As I touched upon earlier last week, Kinder Morgan is trying to combine all companies under a C-Corp corporate umbrella of Kinder Morgan Inc (KMI). The shareholders of Kinder Morgan Management LLC (KMR) will receive shares of Kinder Morgan Inc, which would not be a taxable event for them. Unitholders in Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners (EPB) will receive cash and Kinder Morgan Inc shares in exchange for their units.  This will create a taxable event for limited partners.

Typically, when you purchase units in a master limited partnership, most of initial distributions are treated as a return of capital. Those do not result in a taxable income for the year, but they decrease the cost basis of the unitholder. Once the cost basis reaches zero, the distributions are taxed at long-term capital gains rates. If the unitholder passes away, their children receive a step up basis in the units.

Is your head spinning yet? Basically, if you purchased Kinder Morgan Energy Partners (KMP) at the end of 2002 for about $35, you would have received $46.30 in distributions since then. The first $35 in distributions would have been treated as a return of capital and therefore been non-taxable in the year received. However, they would be tax-deferred only, since a sale would have triggered a taxable event and those would have been payable at ordinary income taxes. The next $11.30 in distributions received would have been treated as long-term capital gains, which receive preferential tax treatment.

If our limited partner decided to sell at $95 today, they would essentially have a long-term capital gain of $60/unit and an ordinary gain of $35/unit. The long-term capital gain will be taxed at 15% for most unitholders, and will result in tax of $9. The ordinary income gain of $35 would be taxable at ordinary income tax rates. Let’s say you were married, and both you and your spouse were in the 25% tax bracket. This would mean that you owe $8.75 in tax on that depreciation recapture. So in total, our limited partner would owe tax of $17.75.

Unfortunately, for those limited partners of Kinder Morgan Energy Partners and El Paso Energy Partners, the acquisition by Kinder Morgan Inc could result in triggering of tax liabilities.

When you sell your units for cash or have them exchanged into shares of Kinder Morgan, this creates a taxable event. In essence, the act of exchanging your Kinder Morgan Energy Partners units for Kinder Morgan Inc stock is treated as if you sold your units for cash. Therefore, a tax is due on all recaptured depreciation at ordinary income tax rates, and at long-term capital gains rates for anything in excess of the purchase price and value received at the time of conversion to corporation. On the bright side of course, if you received $95 in Kinder Morgan shares for your Kinder Morgan Energy Units worth $95, your basis in the shares will be $95. However, now I see why Kinder Morgan decided to offer cash to unitholders. Most will need that cash to pay their taxes on deferred gains.

Of course, you didn’t buy Kinder Morgan Partnership Units just for the tax benefits, did you? You bought Kinder Morgan because you believe in management, you believe you are getting in at a good price, and you believe that in the future the business will be able to generate more cash and pay more back to you. If you choose to hold onto your Kinder Morgan shares however, projections are for dividends to increase by 10%/year through 2020, which is not a bad rate of growth, considering the already high yield on the stock. I like that the incentives of shareholders are aligned with those of the main shareholder Richard Kinder, who i believe to be The Warren Buffett of Energy.

The acquisition of limited partnerships will increase the basis in pipeline and other fixed assets that Kinder Morgan Inc will now own. Kinder Morgan will get to depreciate those assets as if they were brand new assets. As a result, there will be $20 billion in tax savings from the proposed deal. In addition, the structure will be more streamlined, will have lower cost of capital because there won’t be those incentive distribution rights any more.

The lower cost of capital would mean that projects will generate more money right away, and the company would not have to dilute existing holders, because it sells too many units to grow. Retaining some cash flow for funding growth seems like a smart strategy. The company still needs growth projects in order to generate growth to pay for higher distributions down the road of course. Now with a single entity like Kinder Morgan Inc, it could use its stock as currency for further acquisitions. Given the track record of Richard Kinder, I am confident that he would be able to integrate any acquired companies into the Kinder Morgan umbrella quite successfully, while realizing synergies, higher profits for shareholders.

Full Disclosure: Long KMR and KMI

Relevant Articles:

Kinder Morgan to Merge Partnerships into One Company
Richard Kinder: The Warren Buffett of Energy
Kinder Morgan Partners (KMP) for High Yield and Solid Distributions Growth
Kinder Morgan Partners – One Company three ways to invest in it
General vs Limited Partners in MLP's
Master Limited Partnerships (MLPs) – an island of opportunity for dividend investors


9 comments:

  1. The entire post, and some of the other articles I've read on this subject, don't address the issue for KMP investors who hold that stock in tax-deferred accounts such as IRAs or Roth IRAs.

    I'm assuming -- but I haven't seen any confirmation of this -- that the Kinder Morgan restructuring should not have any immediate impact on KMP stock held in tax deferred accounts -- just the same as selling those shares inside such an account and buying something else would likewise not have any immediate tax implication.

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    1. Why should it have any implications for anyone holding KMP in a tax-deferred account (IRA, Roth etc)? It should not - only if UBTI for KMP is positive, and your share of the UBTI is exceeding $1000 - I doubt that for ordinary investors like me that would be an issue..

      There is so much misinformation about taxation of MLPs in tax-deferred accounts, I honestly don't know where to begin. Some confuse UBTI with amount of distributions, others confuse the $1000 in UBTI with amount of units held, others claim to own the units and claim to be having positive UBTI, when in fact the likes of KMP, EPD, OKS have negative UBTI year in and year out. Others talk about "scary stories" about MLPs at tax time. Yes MLPs do issue K-1 forms, but this is not some sort of voodoo - I do my tax by hand, but I know that turbotax can handle a k-1 pretty well. And MLPs like OKS show you exactly what amounts to put, and on which tax form. Even a fifth grader can do that. I believe most of those spreading misinformation is because they do not have first hand knowledge of investing in MLPs themselves.As a result, plenty of ordinary investors are scared about putting any money in MLPs, because of the misinformation they are subjected to.

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    2. DGI

      Superb article that clearly explains the situation at Kinder as well as other MLPs.

      One question, how do you know ahead of time if the MLP will generate positive UBTI? i.e. Perhaps not appropriate for a tax deferred account.

      PS: If you value your time TurboTax is a great time saver especially if you have multiple K1s. I have been using it for many years and it handles K1s quite well.

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  2. Thank you for explaining how the taxes work with this deal. I've only held KMP for a short time in my portfolio, so the tax implications are not as severe for me as they will be for long-time investors. Ultimately I think this will work to my advantage as the tax I will have to pay is modest and the decrease in dividends is offset by the decreased cost of getting my taxes done (the extra filings needed for the K-1s were a problem).

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  3. This tax idea used to be a common asset protection technique used in estate planning. If creditors seized limited partnership shares, they could be on the hook for taxes generated by the actions of the general partner who has the option of not distributing cash to pay the tax bill. For this reason, I never felt it was worth owning MLP shares in a taxable account unless you also happen to be the general partner who gets to call the shots. The tax bill can be even worse if one is subject to the 3.9% surcharge tax that is part of Obamacare.

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  4. Don't forget - any income or losses passed through by the partnership would increase or decrease your unit basis. Your example above ignores that, but in my experience MLPs tend to pass through more losses than gains, so the tax hit may be even bigger. The only positive is, since these are publicly traded partnerships and the losses are usually only allowed to the extent of PTP income, a lot of investors may have "suspended" losses to offset the huge hit this year. Kudos to you for understanding the tax law regarding investing in MLPs, but unfortunately I believe you are in the minority.

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  5. Anon 6:01 here. I forgot to mention my thanks for your tax example in today's post.

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  6. "However, now I see why Kinder Morgan decided to offer cash to unitholders. Most will need that cash to pay their taxes on deferred gains."

    Exactly. In your example, the KMP unitholder will have to shell out $7 ($17.75-$10.77) in cash to pay his deferred taxes -- which he always was going to have to pay, unless the partnership outlived him. Those who have held KMP for less than the 12 years in your example, will have to pay less in deferred taxes and may not have to shell out any additional cash at all. Those that hold KMP in an IRA will not have to pay any taxes from this consolidation. All three will enjoy the capital appreciation of the value of their 2.1931 KMI shares over the $80 KMP unit price the day before the consolidation was announced. In your example, the $95 KMP unit price approximates this capital gain and represents an appreciation of $15 per share. If this holds, and it likely will, the unitholder in your example should have an extra $15, in addition to the $10.77, to pay the $17.75 tax bill. So, in my opinion, not a bad deal for all three types of KMP unitholders.

    It's also my opinion that KM had access to all of the data in your example for each and every unitholder, performed an analysis as you did, and arrived at the $10.77 cash figure to cover the full deferred tax liability of a majority of unitholders.

    Thanks for the article and the example. Also long KMR and KMI.

    -- Bill

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  7. I am looking forward to this as it will simplify my taxes over the long run(will be long on KMI).

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